Dogs of the Dow (DoD)

The Dogs of the Dow (DoD) strategy is
simple: At the start of the year, buy the 10 stocks from the Dow Jones
Industrial Average (DJIA) index with the highest dividend yield,
then reevaluate 12 months later, selling the ones whose dividend yields have
dropped replacing them with new highest yielding Dow stocks.

The rational for the strategy is that the high yield is
indication of a low valuation and eventually the stock price will rise.
Meanwhile DoD investor gets to enjoy the high yield.

The DoD is popular strategy and it has been studied intensively.
The most comprehensive review is by Mark Hirshey (The “Dogs of Dow” Myth,
Financial Review, vol. 35, no. 2, pp. 1-16, May 2000) concluded that from 1961
to 1988 the DoD had a slightly better performance than the total return of the
DJIA; however, from 1989 to 1998 DoD underperformed the DJIA. More recent
results are shown in Figure 1 below. The DoD has underperformed DJIA in the
recent 15 years.

Figure 1. $1 invested in DoD in 1995 would have grown to $2.48 in 2011 whereas $1 invested in the whole Dow (DJIA) would be worth $3.08. The return assumes that the dividends are reinvested.

The relatively poor performance of DoD in recent years may be
due to the popularity of the DoD: When a large number of investors buy the DoD
stocks Jan. 1 every year, the stock price is bid up to the point that they are
overvalued. If this is the case, a better strategy would be to buy non-DoD
stocks. Another explanation is that DoD have a low dividend growth rate and the
market overvalues the continuing growth of non-DoD stocks. Regardless, it is
clear that DoD has not been a winning strategy during the past decades.

While DoD strategy may not be a winner, it is interesting that a
stock strategy can consistently have underperform the index as this goes
against the efficient market hypothesis (EMH): If EMH were to hold, the long
term return of DoD and non DoD stocks should be the same. Since this is not the
case, EMH is not correct; consequently, there must be winning strategies that diligent
investors can use to beat the index average.

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